When does (and when doesn't) a business loan make sense for your small company?

By Reed Richardson

Whether you're a budding entrepreneur looking for seed money or an experienced owner of an established small company seeking to fund an expansion, capital is the fuel that makes small businesses go. When choosing between the two main types of funding-debt vs. equity - there are advantages and disadvantages to each. And, particularly in the current economic climate, the choice over whether or not to seek a business loan merits even more careful consideration to ensure that your small business both survives and thrives.

Debt: hard to get, easier to get rid of?

"The nice thing about debt funding is that it offers small business owners a lot of stability while giving them complete control," says Michelle Bomberger, managing attorney and founder of the Bellevue, Washington-based Equinox Business Law Group. That stability she speaks of comes from the fact that paying back a business loan is easy to plan for from a cash flow management perspective and that the interest on debt is tax deductible. The other advantage of debt funding, she explains, arises from the fact that a bank won't demand voting rights or preferred stock in exchange for their money, whereas a venture capitalist or equity investor might.

Of course, all this presumes that a small business owner can get a loan in the first place - certainly not a sure bet lately. The bursting of the housing bubble and the steep rise in energy prices has had a significant impact on the availability of credit. And this credit pullback isn't just affecting large corporations: A recent Federal Reserve survey of commercial bankers found that more than half had tightened their lending criteria to small companies with annual sales under $50 million. "As shifts in housing and credit markets continue to impact consumers' spending habits, small business commerce will likely experience a slowdown as a result," noted Ryan Scully in a recent Discover Small Business Watch survey.

So for small companies, particularly those seeking to both expand and maintain their operational independence, traditional business loans might appear to be a more difficult route for raising capital, but that's not necessarily the case. "I continue to see my small business clients getting loans," says Bomberger. "Banks are still willing to give credit to small businesses that rate well with the five C's (character, capacity, conditions, collateral, and capital)." And while the first three of these five criteria will vary from person to person, company to company, and industry to industry, the last two-collateral and capital-follow more universal guidelines. According to the U.S. Chamber of Commerce, lenders generally prefer a small business to have between at least a 1:1 and 1:2 ratio of debt to equity on their balance sheet. (Another common yardstick used by lender to measure credit worthiness is debt-to-capital ratios. For a list of preferred ratios by industry, go here: http://finance.yahoo.com/how-to-guide/career-work/12825) "This reassures lenders," explains Bomberger, "because it tells them that you have skin in the game."

Even if your small business doesn't meet these financial criteria, though, it still may be able to obtain a loan, Bomberger points out. That's because many small business loans are "small business" in name only and are instead, from the bank's perspective, tied to the entrepreneur's individual creditworthiness. "A lot of small business owners are surprised that banks still require personal guarantees when they apply for their small business loan," notes Bomberger. She adds that most lenders will continue to demand a personal guarantee on loans until a small business has proven itself (usually until it has attained three straight years of profitability). Of course, legally binding your personal wealth to your small business venture's finances has obvious disadvantages. But by the same token, if a budding entrepreneur is in need of capital and willing to take that risk, they might be surprised to find that they can obtain debt financing - even in today's tighter lending market-if their individual credit profile is strong enough.

Equity: free money that isn't so free after all

Using equity to fund your startup or small business puts you in popular company. Several small business surveys have found that just over half of all small companies were started with privately invested money. In fact, a plurality of entrepreneurs - 31 percent-said they used their own savings to initially fund their companies with roughly another one fifth - 19 percent-saying they received financing from friends and family. This kind of equity financing isn't exactly money for nothing, but it's close.

However, unless your last name is Forbes or Rockefeller, your savings account and the number of relatives willing to write you that "go get 'em" check will probably be exhausted pretty quickly. Consequently, small businesses looking to fund aggressive growth often turn to the next level of equity financing-venture capitalists and angel investors. These more mature sources of equity also carry a whiff of "money for nothing," as they have the potential to inject millions of dollars into a company almost overnight, all without charging interest or demanding immediate repayment. That kind of boost to the bottom line not only helps a small business owner's cash flow, it can have intangible benefits as well, attracting high-profile talent and providing an infusion of confidence and enthusiasm.

In addition, equity financing tends to be more resilient to market fluctuations and quicker to rebound when there are downturns. According to Jeffrey Sohl, director of the Center for Venture Research at the University of New Hampshire, total funding from angel investors was off 30% during the first half of 2009 when compared to the same period a year earlier. However, the number of overall investments increased slightly-from 23,100 to 24,500-and Sohl expects these trends to at least remain steady, rather than decline further, through 2010. (For a directory of angel investors and venture capital firms, check out the new search engine launched by the company Angelsoft last year: http://angelsoft.net/startup-tools/investor-search)

Make no mistake-in spite of its many attractive features, equity financing does bring with it costs, some of which can be especially difficult for strong-willed, go-it-alone entrepreneurial types to accept. Unlike business loans, which create a temporary relationship between your company and a lender, equity financing typically results in your business gaining permanent partners. In addition to sticking around, these new partners often demand a say in how the company will be run, a situation that might run counter to the very reasons a small business owner started his or her own company in the first place. And because properly documenting these private equity partnerships can be expensive-between $8,000 and $15,000 to complete the necessary legal paperwork-small business attorney Bomberger says that equity financing really doesn't make sense for small amounts of cash, even in the current economic climate where credit is harder to come by.

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